Introduction
Uses of preferred equity
Terms and structuring of preferred equity
Preferred equity as an investment instrument remains a useful and increasingly popular financial tool for both investors in, and sponsors of, real estate investment transactions.
In many instances, preferred equity replaces mezzanine debt; in others it supplements mezzanine debt in the capital "stack". The terms and structuring of preferred equity remain relatively sui generis and case-specific, and transaction documents vary widely from one investor to another.
Preferred equity may be a replacement for mezzanine debt financing of US real estate in situations where an intermediate level of financing senior to common equity but junior to first mortgage debt is needed in the capital "stack", but where the senior mortgage debt objects to having mezzanine debt present. This may be because the senior debt underwriting prohibits mezzanine debt or because the senior lender wants to reserve the right to split its senior loan into mortgage and mezzanine components at a future date.
Preferred equity may also be a useful supplement to a capital structure that already includes mezzanine debt, but where the sponsor requires additional capital, such as in a workout or development transaction. In such circumstances, a sponsor may consider preferred equity as a means of obtaining additional capital without unduly diluting its common equity position.
Moreover, preferred equity may be structured as either debt or equity for US tax purposes, which makes it particularly useful in structuring investments by non-US investors and US tax-exempt investors in US real estate.
Terms and structuring of preferred equity
Unlike senior mortgage debt and mezzanine debt terms and documents, where sponsors and capital providers generally encounter well-established terms and forms, preferred equity investment terms and agreement vary widely because the term "preferred equity" is used to denote investments that range from debt-like instruments, which look and act like mezzanine debt in all but name, to equity-like instruments with only modest seniority in certain areas over common equity. Terms provisions vary widely from transaction to transaction – terms such as:
- liquidation preferences;
- distribution priorities;
- governance rights;
- negative and affirmative covenants;
- transfer restrictions;
- step-in rights;
- redemption provisions; and
- exit.
In addition, preferred equity may be drafted as a standalone document or in the form of an amendment to the sponsor's existing common equity vehicle, resulting in a variety of documentation formats. The flexibility of preferred equity terms makes it adaptable to a variety of investment situations – from initial acquisition investments to expansion capital, to pre-exit bridge financing and workouts.
For further information on this topic, please contact David Warburg at Seyfarth by telephone (+1 (704) 925-6025) or email ([email protected]). The Seyfarth website can be accessed at www.seyfarth.com.